Strategies for investment in inflation, currency and commodity markets in India

The Indian Rupee has depreciated more than 20% over the last three months. Has this got more room to go? We try to answer this question by analysing FII portfolio flows into the country, mainly in the context of developments taking place in the United States on the monetary policy side.

The down-slide in the Rupee was triggered in May 2013 when the United States Federal Reserve Bank (Fed) chairman, Ben Bernanke, indicated a potential reduction in its bond purchase programme later this year. The Fed chairman’s stance is supported by continual improvement in economic data in the US and has led many investors to believe that the Fed’s ultra-loose monetary policy (including near zero interest rates and quantitative easing (QE)) might be coming to an end.

The Reserve Bank of India announced further measures to contain foreign exchange volatility in India. The Central Bank has announced to tighten liquidity further by issuing Cash Management bills once every week for an undefined number of weeks. This underlines RBI’s resolve to contain inflation despite significantly weak economic growth outlook. Meanwhile, Treasury bill rates have increased beyond Bank Fixed Deposit rates and offer an interesting investment avenue to retail investors.

In its effort to contain the Rupee exchange rate volatility, the Reserve Bank of India has announced that it will auction Rs. 220bn (US$ 3.6bn) of cash management bills once every week on Mondays. The number of weeks for which these sales will be conducted has not been announced but in absence of any further details, this may be assumed open-ended. This measure follows other liquidity tightening measures that the RBI has taken over the recent few weeks including announcing a tight cap on the amount that banks can borrow from the central bank under its ‘liquidity adjustment facility’ window and raising the Marginal Standing Facility rate (under which banks can borrow from the RBI at a penal rate) by 200bps.

This comes at a time when economic growth in India is decelerating. According to RBI’s first quarter review (2013-14) of macroeconomic and monetary developments:-

“Recovery in growth may take time and is expected to shape slowly as the year progresses. Moreover, sustainable recovery requires control over consumer price inflation that has continued to hover around double digits for the past 15 months.”

This inflation fighting stand by the Reserve Bank of India in the face of weak economic growth is interesting. Meanwhile, the central bank today published a study titled ‘Real Interest Rate Impact on Investment and Growth – What the Empirical Evidence for India Suggests?’ on its website. The study concludes that while lower real interest rates are needed to stimulate growth, these cannot be achieved by adopting a policy of high inflation tolerance. Beyond a threshold the negative impact of inflation on growth outweighs its positive impact through lower real interest rate. In other words, it underlines the central bank’s efforts to control inflation at the cost of short-term pains in the money-market.

Overnight call money rates have continued to remain high and may inch higher after today’s announcement. Meanwhile Treasury bills (and Cash Management bills) offer an interesting avenue for investment to retail investors. As can be seen from the chart here, T-bill rates are now offering higher than bank fixed deposits (FDs). Given the adverse effects RBI’s liquidity tightening measures are having on banks’ balance sheets (the Bank NIFTY index is down 13% since 15th July), it makes all the more sense from a credit perspective for retail investors to diversify funds out of Bank FDs into relatively safer Government bills.

Government of India to re-issue Rs. 1000 crore of 1.44% Inflation-Indexed Government Stock – 2023 on June 25

AUCTION RESULT: CUT-OFF YTM = 1.9855%

This auction comes amidst market turmoil. The latest Fed shenanigans have caused some to even wonder if this is a repeat of the asset price movement seen during late 2008. Data from China adds to worries of a mass pull out from emerging markets (Chart 1: investments by Foreign Institutional Investors in India during June-2013). In this backdrop, finding buyers for this newly launched product is likely to be difficult.

Notwithstanding this, current valuations (@1.68% real yield) for the inflation-indexed Government security (IIB GS June-2023) could hardly be more compelling. As chart 2 shows, the IIB real yield has risen 27bp since its launch on 4th June[1]. This rise has been almost in line with the increase in the yield of the current on-the-run 10-year benchmark nominal security 7.16% G-sec 2023.

1) The 27bp rise in the real yield could be seen as a buying opportunity. Fundamentals for the Indian economy have not changed over the last fortnight. Expectations for GDP growth continue to remain weak (if not weaker than before) and, whilst not in July, the RBI is likely to cut rates at some point during the course of the year.

2) The Rupee has weakened more than 5% during the month of June. This move should potentially be inflationary over the medium term. However, the fact that the real bond yield has risen as much as the nominal G-sec yield (i.e. their breakeven rate has been almost unchanged) suggests that market participants have not yet priced in any inflation expectations in this market.

View: On this occasion, the Bernanke driven trend in the market looks too strong to overwhelm valuations. FIIs are least likely to participate. However, a Rs. 1000 crore auction is not big enough to weigh on the market. Cut-off estimate: 1.75%.

A number of fixed income securities are available for investment by retail and institutional investors in India. The chart here shows the current yields being offered in the market. Worth noting is that the Government yield curve is flat at current levels. High yields at the front-end probably reflect the tight money liquidity situation in the market. Could this be temporary?

The IIB launched on 4th June offers a positive carry (over the repo rate of 7.25%) over the next three months. The cumulative carry profile is shown in figure 1. As can be seen, carry decreases during July, before rising sharply in August.

Carry is the extra interest income earned from a fixed income instrument over the cost of borrowing funds needed to invest in the security.

Unlike conventional nominal government securities, carry in inflation-linked bonds varies with spot inflation. As discussed in one of our previous notes (estimating the real yield for the IIB at the auction on 4-June-2013), inflation experiences seasonal fluctuation throughout the year. In certain months the monthly inflation rate may also be negative. Given that the inflation-linked bond principal accretes in line with the inflation index, its carry also varies with inflation.

The typical way of estimating carry from a Government security is to work out the forward yield for a forward date (using the borrowing rate) and subtract the spot real yield from it. The difference is the carry (in bp) offered by the security over that period.

For the IIB 1.44% GS 2023, since we know the inflation numbers until April, 2013, we can work out its forward yield (and therefore carry) over the next three months. I have worked out the daily carry in the bond and show on a cumulative basis in chart 1. (I have assumed the cost of borrowing to be 7.25%, which is the current repo rate)

As can be seen the carry profile increases up until end of June after which it decreases until end of July. This decrease is because of the negative monthly inflation (realized) between February and March 2013. Thereafter there is a sharp increase in carry because of the +0.5% monthly inflation seen in April.